Just take the contrast between hedge funds and investment newsletters. The former occupy a rarefied corner of Wall Street, supposedly filled with the best and the brightest. Only qualified, high-net-worth investors are even allowed to engage their services and most individuals feel deprived that they don’t have access.

At the opposite end of the spectrum are investment newsletters, supposedly edited by a bunch of lunatic self promoters whose research departments are no bigger than their kitchen tables. This is the domain of the small, individual investor.

Are hedge funds overhyped?

(3:47)

Hedge funds are having a mediocre year at best. Is it time to consider other options? Mark Hulbert joins discusses on Markets Hub.

Well, guess what? The newsletters this year are handily beating the hedge funds. The average newsletter, according to the Hulbert Financial Digest, has produced a year-to-date gain (after transaction costs) of 9.0% — after taking transaction costs into account.

In contrast, the average hedge fund, as measured by the Hennessee Hedge Fund Index, has gained 5.5%. (These numbers are through November.)

To be sure, longer-term data paint a somewhat better picture of the hedge fund world — though not sufficiently better to justify an inferiority complex on the part of newsletter editors or retail investors.

Over the last decade, according to the Hennessee Group, the average hedge fund has produced a 6.6% annualized return, versus 6.3% for the average investment newsletter. That’s a surprisingly small difference, given the stark differences between the two categories of advisers.

Naturally, the hedge fund world believes that raw performance numbers fail to capture the true value that is being added by hedge funds. One major category of value added, they argue, is reducing volatility. After all, that’s the reason they are called hedge funds.

But how much volatility are they really reducing?

Again courtesy of data from the Hennessee Group, I was able to measure the extent to which the average hedge fund is correlated with the overall stock market, as measured by the Wilshire 5000 index.

The metric I used was the correlation coefficient, which ranges between minus 1 (when there is a perfectly inverse correlation) and plus 1 (when there is a perfectly positive correlation). When focusing on monthly returns over the last 20 years, the correlation coefficient was a surprisingly high 0.80.

And, high as this was, it undoubtedly underestimates the true extent of the correlation. That’s because hedge fund holdings often are illiquid, and are therefore priced relatively infrequently. As a result, when calculating their net asset value at the end of a given month, hedge funds often end up using stale, out of date, prices for their illiquid investments.

One now-famous study of this phenomenon appeared a decade ago in the Journal of Portfolio Management, entitled “Do Hedge Funds Really Hedge?” The researchers found that, after correcting for this effect, hedge fund returns were significantly more correlated with the stock market than otherwise appears. Click here for the study.

None of this is to say that there are no good hedge funds out there — or that all investment newsletters are worth following.

But along with the good hedge funds there are plenty of bad and ugly ones too — just as is the case with investment newsletters, or any advisers for that matter. Our focus in all cases should be on which have good long-term track records, rather than on the particular corner of Wall Street they inhabit.

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